What does the war in Ukraine mean for the geopolitics of energy prices?

Global energy prices have risen sharply, primarily as a result of the invasion of Ukraine and European efforts to move away from dependence on Russian oil and gas. But increased demand in Asia and struggling production from shale in the United States are also having an impact.

Since Russia’s invasion of Ukraine on 24 February, the geopolitical and economic importance of energy has been plain to see. The war has brought higher energy prices, with knock-on effects for the cost of living crisis in the UK and elsewhere.

During the first two weeks of the war, Brent prices – the European oil benchmark – increased by more than 25%. By the end of March, European gas prices were around 580% higher than a year earlier. While they have fallen back since then, this is in part because many European companies have accommodated Russia’s demands to pay for exports to a non-sanctioned Russian bank to facilitate Gazprom (Russia’s majority state-owned energy company) receiving roubles.

In Europe, the continent’s acute foreign energy dependency has proven divisive. At a summit on 10-11 March, the countries of the European Union (EU) collectively agreed to phase out imports of Russian energy. But where immediate sanctions are concerned, national interests and geopolitical judgements prevail.

Five weeks into the war, the Baltic states suspended purchases of Russian gas. By contrast, over the same weekend, politicians in Berlin took to the TV studios to explain the likely systemic consequences for the EU’s industrial powerhouse of reducing energy supplies from Russia. Where oil is concerned, the EU has been discussing a sanctions package for some weeks without being able to reach an agreement.

The war-induced energy shock is far from the only disruptive force around energy coursing through the world economy. There are now three different structural shocks at work, each with geopolitical implications.

The first comes from the disturbance that Russia has inflicted on itself. The country is the world’s biggest exporter of natural gas, the second largest crude oil exporter and the third most significant coal exporter. Around three-quarters of Russia’s gas exports go to Europe and Turkey. Most of this westward-bound gas arrives via pipelines.

To expand imports to Asia to compensate for the European market share that it may lose over the next few years, Russia will have to build a second gas pipeline to China and substantially increase its liquified natural gas (LNG) capacity at Sakhalin 2 on the Okhotsk Sea.

Here, the corporate partners of Gazprom have been both European (the Anglo-Dutch company Shell) and Asian (the Japanese companies Mitsui and Mitsubishi). Shell has announced that it will quit its equity partnerships with the Russian gas behemoth, while Mitsui and Mitsubishi have promised to stay. This means that a parting of ways between Europe and Asia over corporate partnerships with Russian firms is under way.

The second shock is rising gas demand in Asia, especially China. The growth rate of Chinese consumption has accelerated since 2016. In 2021, it surged, as China recovered from the pandemic and accelerated its moves to replace coal with gas in domestic heating. With the country’s LNG imports rising by 19% over just 12 months, China took over from Japan as the world’s largest LNG importer.

Even though Europe’s largest economy, Germany, does not import seaborne gas, EU gas futures rose more than tenfold between March and late December 2021. The price spike that December was so severe that American LNG ships heading for Asia made an about turn towards European ports, pricing Asian countries out of the American spot market for the first time.

With European countries committed, for the medium term, to substituting American and Qatari LNG for pipelined Russian gas, this European-Asian gas competition can only intensify.

The third shock comes from the United States. For the best part of the 2010s, the shale boom supplied the oil that allowed the world economy to avoid an energy-driven slump. At the start of 2020, American output was 13 million barrels per day (bpd). But even when oil demand began to recover from the pandemic shutdown, the shale sector did not.

By the end of 2021, American production stood at only 11.6 million bpd. Burned by the pandemic-induced crash in oil prices in March 2020, investors began demanding that the heavily indebted shale companies practice greater capital discipline and prioritise returns over short-term output.

Meanwhile, the large Bakken field in North Dakota that initially drove the boom appears to be in decline. Without spare domestic capacity, the Biden administration has resorted to asking the Arab members of OPEC Plus (the producer cartel formed by Saudi Arabia and Russia in November 2016) to provide more oil, but the Saudis see little reason to oblige Washington.

The geopolitics of both energy consumption and energy production are now destabilising. These problems will intensify the desire to speed up the move to increase renewable energy output and reduce fossil fuel energy consumption. But the multiple energy shocks are also driving up the manufacturing and supply chain costs around renewable energy.

For the foreseeable future, high fossil fuel energy costs are entrenched in the world economy and will only come down through slower growth and eventually recession.